| Understanding The Differences Between CFDs And Margin Lending |
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| Written by Ben McGrath |
| Thursday, 05 August 2010 20:26 |
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In the early days investors wanting to borrow money to invest had few choices, either borrow money from the bank to buy shares or call your stockbroker and apply for a margin loan.
In the early days investors wanting to borrow money to invest had few choices, either borrow money from the bank to buy shares or call your stockbroker and apply for a margin loan. It was in 2003 that traders in Australia we introduced to CFDs. The introduction of CFDs changed the industry. CFDs have become one of the fastest growing financial products in history, outstripping the growth seen in warrants in the 1990's. With CFDs retail investors do not need to apply for a bank loan or deal with their full service broker. CFD providers now allow retail investors to open up an account on-line in minutes and start trading on the same day. CFDs are executed on-line in real time, their efficiencies have revolutionised the on-line trading industry. Unlike margin lending CFDs are typically traded over the internet with the trader's portfolio being marked to market in real-time throughout the trading day, this is substantially different to the end of day portfolio revaluations used by traditional margin lenders. Real time portfolio margining means that traders can properly manage risk throughout the trading day rather than having to wait for statements to be generated at the end of the day. Like shares bought using a margin loan CFDs also offer the holder the ability to receive a dividend, however in most cases franking credits are not passed on the holder of a CFD unlike that that of a margin loan. The reason franking credits are not passed on when holding a CFD is because the owner of a CFD holds an over-the-counter derivative contract and not the physical share. Not owning the physical share when holding a CFD position also means that the owner of the CFD is not entitled to voting rights in the listed company over which the CFD is based. Many CFD traders only hold their positions for a short period of time and are not interested in voting or franking credits but instead are interested in making a profit from the short term price changes of the CFD. A major advantage of CFDs is that they can be bought an sold on-line with ease. CFDs allows traders to go long just as easily as going short this allows profits to be made in market downturns. With traditional margin lending it is extremely difficult to short sell or go short, traders are required to enter into complex stock borrow agreements and abide by exchange short selling rules. CFDs have cost advantages over margin loans. A stockbroker will often charge 0.50 percent commission whereas the average CFD broker will charge 0.10 percent. It is important to note that there are significant differences in the way interest is charged on a margin loan and a CFD position. Most CFD providers will charge interest on the full notional value of the position whereas margin lenders will only charge on the borrowed amount. Although it may appear that charging financing on the full notional value is more expensive often the actual financing rate CFD providers charge is much less than the rate charged by margin lenders. Although it is important to consider the financing cost, most CFD traders incur little or no financing as CFD positions are often held open for relatively short periods of time. CFD traders are able to earn a better return on their capital outlay as the leverage offered by CFD providers is often more than that offered by margin lenders. It is important to note that although leverage can result in an increase in returns it also results in an increase in risk. Some CFD providers offer leverage as high as 100 times whereas most margin lenders will only offer around 10 times leverage or less. The leverage offered by CFD providers and margin lenders vary's and is determined by the liquidity and market capitalisation of the stock which the CFD is offered over. CFDs cannot be transferred from one provider to another this is simply because CFDs are over-the-counter derivatives and can only be closed with the CFD provider the position was opened with. As margin loans entail the purchase of the actual shares the holder of the margin loan is fee to transfer their share portfolio from one broker to another. CFDs suit short to medium term active traders looking to take advantage of market movements in both directions, however, margin lending is better suited to people who are looking for long-term investment opportunities and to take advantage of the tax benefits franking credits provide. It is important to remember that both products are leveraged and you should ensure that you adopt a proper money management plan. DISCLAIMER: This article is provided as information only and is not to be taken as financial advice. Learn more about CFDs. Stop by Ben McGrath's preferred site where you can find out all about CFD trading and what it can do for you. |